Tuesday, 24 July 2012

Changing the Incentive Structure of Anglo-American Corporations

There is a clarion call to reform aspects of capitalism in order to address the problem of financial instability - an economic externality which has resulted partly from short-term financial behaviour and overleveraged institutions and sectors. Professor of Law at Case Western University, Lawrence E. Mitchell, says in a recent piece that a significant cause of the financial crisis has been the disappearance of corporate equity funding and its replacement with debt over the course of the 20th century, debt which has more recently been off the balance sheet. Furthermore, he explains, sources of capital gains have shifted from profits reaped through retained earnings to future profits in the form of velocity-induced trading gains. Professor Mitchell asserts that the very sustainability of American industry and the future wealth of America are at risk when shareholders or mangers on their behalf gamble with debtholders’ money, spending today the future profits of American industry.

Since about 1962, common shareholders in the US have actually withdrawn more money from corporations than they have invested – this is apparent from the disappearance of retained earnings from corporate balance sheets and trends in net issuance of common stock. By 2002, retained earnings had dropped on average to 3% (from 50 to 60% from the beginning of the 20th century until the early 1960s), returning to 11% by 2007. Retained earnings which had represented permanent stockholders’ equity were replaced by debt, much of this off-balance sheet financing.

Shareholder capitalism is based upon laws, which in turn were based on principles of economic utilitarianism, which place ultimate control or a corporation in the hands of shareholders who elect the board of directors; it’s the stockholders as the residual claimants of corporate wealth who are meant to bear the greatest risk. Professor Mitchell says that trends in the debt/equity ratio have actually resulted in investment in corporate America which is almost nil and that the real riskholders are the creditors.

Thus we have the dangerous anomaly of boards and managers
managing for shareholders (with shareholder interests in stock price
maximisation and shareholder taste for risk) with creditors’ money. This ability to use other people’s money for
shareholder profit creates powerful managerial incentives to short-change the
long-term health of the corporation for short-term gain, putting the American
productive sector at risk…pre-crash (2006), over 30% of the profits of American
corporations classified as ‘industrial’ came from financial transactions rather
than the production of goods and provision of services. And financial assets constituted almost 48%
of the total assets of non-farm, non-financial corporations.[1]

In order to protect the sustainability of American industry
and its ability to create permanent and transferable wealth, Professor Mitchell
recommends that incentives are created for investors to reap the
rewards of their investments through industrial profits rather than market
speculation. His specific suggestions
include the following:

building long-term investing into the initial investment decision by developing a sliding scale capital gains tax

returning to largely insider boards

making appropriate accounting changes to rely more heavily on cash flow than income statement accounting.

Professor Mitchell, along with Professors Lynn Stout, Martin Lipton and Margaret Blair are the most well-known of the ‘board primacists’ – a group which advocates against greater ‘shareholder democracy’ in favour of increased board discretion. They argue that shareholders need to delegate their authority in order to allow the board to manage the enterprise free of short-term pressure. They believe that facilitating shareholder democracy and shareholder power would create greater costs than possible benefits. Board primacy theorises that because shareholders are a heterogeneous group, their objectives are not uniform; therefore they believe corporate law requires re-theorising in light of this new reality.

On the other hand, there has also been a groundswell of support for greater shareholder education, communication and involvement among some corporate governance academics who base their thinking on the claim that the board primacists conflate two aspects of the processes by which group decision are taken; these two are the responsiveness of the governance system and the composition of the shareholder electorate. Professor Grant Hayden of Hofstra University and Professor Matthew Bodie of Saint Louis University are two who say that because of this association, board primacists are arguing for governance structures that put greater distance between the shareholder electorate and the board which could have serious negative consequences.

Hayden and Bodie believe that by restricting the decision-making
franchise,” board primacists have detached their governance structures from the
underlying desires of their constituents without substituting anything in their
place.” They argue that “the breakdown
of this particular distinction between shareholders and constituents could mean
that we should investigate treating other constituents [variously defined but
typically include shareholders, employees, suppliers, customers and creditors,
sometimes expanded to include neighbours, towns or society ]more like
shareholders, rather than the other way around.”[2]

Andrew Clearfield of Investment Initiative corporate
governance consultancy is also a voice on the side of responsible shareholder
involvement, being himself a former portfolio manager. He believes that because shareholders are
widely dispersed, management can behave as
if they were the principals of a company rather than its agent. Professor Stout says that when managers behave
in such way, it’s difficult to bring them to heel; hence her preference for
insider boards. Mr. Clearfield says, “and
unfortunately, history is replete with examples where exactly this has
happened, to the detriment of shareholders (and often almost everyone else as
well).”[3]

He describes the fact that there are both short-termist,
high-turnover shareholders who dislike the idea of shareholder activism in
governance but that there are also shareholders who take significant positions
and actively work to foster change from inside a company, remaining involved
for many years:

There are
governance-oriented investors who engage actively with their holdings not
because they are planning to flip them, but on the contrary, because they
expect to be involved for the long haul.
There are short-term investors who are essentially arbitrageurs, and who
try to hide behind a mask of concern for governance, when all they really want is
to stimulate an event or transaction which will enable them to exit at a
profit. And there are all sorts of
shades in between.[4]

Mr. Clearfield challenges the assumption which board
primacists make of director and senior management benevolence; he says that an emphasis
on options incentives – which were not implemented on the insistence of
shareholders – have often become detached from reasonable performance criteria
and that managers have found various ways to game the release of favourable results
and pricing of their share options. The
homogeneity of boards is another red flag Clearfield and many others cite as a
problem for corporate governance: “Directors constitute a sort of club united
not only by social ties but also by mutual economic interests. They sit on each other’s boards and do not
make waves….they become followers rather than leaders. That should not be their function.”[5] He cites boardroom duplicity for the
failures of GM, Kodak, Hewlett-Packard, BP and Enron.

Like many corporate governance reformers, Mr. Clearfield advocates
shifting corporate focus to the
long-term by changing terms of executive incentives (to vest over longer
periods with clawback provisions for illusory results), ceasing to give
analysts earnings guidance and abolishing quarterly earnings statements (as
John Kay recommends here in the UK).
“Make the market cool its heels and wait for longer term results, and it
will have to take a longer-term perspective.”

The board primacists are concerned about short-termist
investors or the few hyper activists who desire to micro-manage a company. For Mr. Clearfield, the danger isn’t that the
majority of shareholders will take their lead from the few prominent activists,
but rather that they won’t pay enough attention to corporate governance to even bother to vote out a board
which manages disastrously. This is the
scenario that has been more of a concern to those with a more macro view of public
outrage over corporate fraud, corporate governance reformers like Lord Myners
and the government. Though the system
has been prone to abuse by the short-term interests of the opportunists, “incumbent
boards and managers who have large positions in the equity themselves are
guilty of this at least as often as dispersed shareholders.”[6]

The board primacist professors, Stephen Bainbridge, Margaret
Blair and Lynn Stout argue that if boards were able to take decisions free from
shareholder pressure, they would make better choices about how the firm should
be run. Professors Hayden and Bodie refer to these commentators
as ‘wise ruler’ theorists because they attribute the board with great acumen
and invest them with great power; critical to board performance, they claim, is
their independence and insulation. Hayden and Bodie have a different
take; they say that the goal of the corporation is not just shareholder wealth
maximisation but that the directors owe a duty to the constituents of the corporation,
which consist of all stakeholders including shareholders, employees, creditors
and the local community. According to
this model, stakeholders contribute their resources to the enterprise with the
implicit bargain that the company itself will fairly apportion responsibilities
and rewards. [7] The board is hired by the stakeholders to
serve as the apportioning body; it is an agent, but has authority over stakeholders
in order to carry out its function. So
in actual fact, the role of the board is more of a trustee than an agent.

Two board primacists, known as the “long-term interests”
theorists include Professors Lawrence Mitchell and Martin Lipton who are
critical of the short-term perspective of shareholders but their concern is
more to do with the long-term efficiency of the corporation. Professor Mitchel proposes self-perpetuating
boards with complete freedom from shareholder oversight which he believes would
enable them to manage responsibly and for the long term.[8] In this model, shareholders have a limited
role but election time would become a time for a more meaningful vote on the
company’s future.

If shareholders are left with even less power in corporate
governance than they already have today, the corporate good may become more
detached from the actual preferences of the firm’s constituents. Hayden and Bodie argue for a radical
change: they say that with respect to their preference profiles, shareholders
are more like other corporate constituents than once thought:

Instead of focusing on the fact that
shareholders are now as ‘bad’ as other constituents for the purposes of
corporate governance, we could view this as evidence that the other constituents
are just as ‘good’ as shareholders, a least in this respect. That is, the breakdown of this particular
distinction between shareholders and other constituents could mean that we
should treat the other constituents more like shareholders rather than the
other way around.

They therefore suggest
expanding voting systems to include other constituents besides shareholders. And though they recognise that there may be
difficulty in arriving at an accurate and manageable way of identifying
specific members of a constituency, like customers, for an election, ‘the
breakdown of the fundamental distinction between shareholders and other constituents
should at least force a re-examination of the scope of the corporate franchise.“[9]

These suggestions would be a major step in the transforming (or
returning) the current Anglo-American shareholder corporate structure into
stakeholder capitalism. There’s a
powerful argument that such a change could usher in a more stable, efficient,
sustainable and responsive corporate system with better informed, engaged and responsible investors.